I rarely advocate That clients file Chapter 13’s because they take too long and keep them under the thumb of the bankruptcy court for (usually) five years. So when does it make sense?
It makes sense when you want to keep your house but have junior unsecured liens stacked on top of the main mortgage. In Chapter 7, if you want to keep your house, you have to keep the lenders current. Not necessarily so in Chapter 13 when you have stacked loans secured by your home. Since 2006, the Heavy Question [see clever illustration below] has been: Can you dump a mortgage loan in Chapter 13? The short easy answer if you’ve ever read anything at all on my blog is that “it depends.”
First: Is it “secured” solely by your primary residential real estate? And by that I do not mean investment property or personal property. (Pay attention here because the terms and definitions matter.) That is, is the security agreement only applicable to your primary residence? If so, you have passed the first test.
Second: Is it WHOLLY unsecured? By this is meant that there is no security for the loan at all after consideration of all senior debt. Example: House valued at $750,000 With a first deed of trust (“DOT”) for $690,000, a second DOT for $170,000, and third DOT $75,000. Now what?
Well, the first is wholly secured because the value exceeds the loan balance by $60,000 ($750,000 minus $690,000.) Our hypothetical borrower can’t strip this lien because it is wholly secured.
The second is partially secured. It is secured to the extent of the $60,00 left after accounting for the first DOT right? $750,000 minus $690,00 leaves $60,000. Capiche? So because it is partially secured, you can’t strip it and the debtors will have to keep that lender current In order to keep the home.
But the third…Here’s where it gets interesting. After accounting for the first and the second, there is no security value left for the third at all. $690,000 plus $170,000 equals $860,000. But the house is only worth $750,000. Because the third is wholly unsecured, the borrower can “strip” this lien and shove the debt over to the unsecured column…Payable over the time of the Chapter 13 plan.
Why do we care? Because you can’t do this in Chapter 7. It only works in Chapter 13.
This concept as described also only works in parts of the country, so don’t go charging into your bankruptcy lawyer’s office telling him or her all about how you read on the web that you can dump your HELOC. There’s a bit more to it than the above, but this sort of scenario and fact pattern is a good example of when a Chapter 13 might make sense.
In a couple of other places in this blog I have discussed various components of California’s mortgage anti-deficiency laws. (See California Mortgage Deficiencies: What is a Purchase Money Security Interest? and Second Mortgages in California: Deficiencies Not Usually an Issue.) This post will put it all in one place. At least the five basic rules.
I can’t warn readers enough, however, that these are very, very complex issues. I have–quite intentionally–over simplified them here, and I have done this to provide a precis on the big picture. The case law interpreting the applicable statutes occupies volumes in California lawyers’ offices, and there are still many legal issues and questions that are unsettled. So please go easy if I don’t answer your specific question here. There is no way I can address all of the issues in one post, so if you have a specific question, please, post it in the comment section so everyone can see it, and I’ll do my best to answer it. But if you think you have a deficiency problem, or a possible exposure to a deficiency judgment, you really owe it to yourself to see an attorney who understands these issues. Also, bear in mind that the rules vary from state to state, so if you are reading this post with a real estate problem in any place other than California, you can be sure that the rules applicable to your situation are not the same.
First, what is a deficiency? Simply stated, a deficiency is what is left owed to a lender after the lenders forecloses and takes the real estate back. Example: If I owe $200,000, and the property is only worth $150,000 there is a so-called “deficiency” of $50,000. When can the lender come after the borrower for that “deficiency?” That is the subject of this post. And, of course, in the current economy, a lot of people are trying to figure this out.
In California, there are four primary rules that apply. I discuss them below in no particular order.
1. The One Action Rule. CCP §726(a).
The One Form of Action Rule basically says that the lender is required to chase the collateral first, and the debtor second…if it still can. A long, long time ago, a foreclosing lender could choose whether to foreclose on the collateral or go after the borrower personally for a money judgment. The one action rule of CCP §726(a) says that the lender must go after the collateral first, and, if it is legally possible, go after the borrower personally for any deficiency after that. Whether that is possible will depend on how the other rules set forth below kick in and apply to protect the borrower. But if you get sued on a promissory note and the lender is not a “sold out junior” nor taken hasn’t taken steps to foreclosure on the collateral, this rule would apply.
(I use the term “sold out junior quite a bit in this post. A sold out junior lienholder is the holder of a deed of trust that is junior to the first lienholder, and who has been denied a recovery due either to the foreclosure by the first lienholder, or because there isn’t enpugh value in the property to satisfy the junior debt after satisfaction of the senior debt. It is common for people to refer to such debts as “HELOCS,” but this isn’t technically accurate. A HELOC is simple a “home equity line of credit” that is secured by the subject property. It may be the most senior debt on the property or it may be a second, third…or tenth lien in order of its seniority. “HELOC” is a banking term; “sold out junior lienholder” is a legal term of art.)
2. The Purchase Money Prohibition: CCP §580b.
This is the best known rule and the one that applies more often than the others. If the loan that is being foreclosed on is a loan that was obtained for the purpose of purchasing the property, then no deficiency is allowed. It doesn’t matter if it’s a first, second or third. It doesn’t matter if it’s classified as a “HELOC,” a “seller carry back,” or, ultimately, a “sold out junior.” Purchase money is purchase money. Example: Homeowner buys a house for $300,000, with a first for $200, and a second for $60,000, both put on the property at the time of acquisition. If the first forecloses, both lenders are barred from getting a deficiency because both loans are classified as “purchase money.” However, where the borrower has refinanced the original purchase money loan, or got a later home equity loan, that later loan is not a purchase money loan and could form the basis for a deficiency if the other anti-deficiency rules don’t otherwise apply.
But there is an exception to the exception: If the later loan was used to finance improvements to the property, then it can be a purchase money loan, and thus be a bar to a deficiency.
3. The Non-Judicial Foreclosure, or “Private Sale Bar”: CCP §580d.
This is the next most frequent rule. If the foreclosing lender has availed itself of the “power of sale clause” in the deed of trust, then no deficiency is allowed. Period. If they take the property back by means of a non-judicial foreclosure or trustee’s sale, then no deficiency. But unless one lender holds both loans, that only applies to the loan actually foreclosed on. Using the above hypothetical figures, though in this case making the second a non-purchase money loan, when the first forecloses, the holder of the first foreclosing loan is barred from seeking a deficiency both (1) Because it is purchase money, and (2) Because it has foreclosed by trustee’s sale. But the second, not being purchase money, and not being the one who foreclosed by non-judicial sale but having been wiped out by the foreclosure of the first, is not barred from pursuing a deficiency. In fact, in California, they have up to four years from the date of the breach of the contract to file a lawsuit seeking that deficiency.
And of course, as noted, there is an exception to the exception: If the holder of the first and the holder of the second are the same lender, and that entity forecloses on the first, it is also barred from seeking a deficiency on the second. This is important in California where lenders sometimes “stack” loans in order to get to a loan amount high enough to cover the high property values. It is also important to think about when the loans may have been sold to different lenders.
(On a historical note, CCP §580d was passed in light of the foreclosures and abusive deficiency judgments obtained by lenders during the Great Depression. What we’re going through now is similar in many respects, though the ability of lenders to take the property and then chase the borrower who is already out of their home is limited by the passage of that statute. Small solace, to be sure, but it at least is doing what it was intended to do.)
4. The fair Value Limitation: CCP 580a; CCP §726(b).
This rule limits the amount of any possible deficiency to the amount by which the total debt exceeds the total fair value of the collateral. It only applies to deficiency judgments in judicial foreclosures, and, most importantly, it does not apply at all to sold out junior lienholders. Example: First mortgage of $450,000, and a second for $150,000, for total liens of $600,000. If the holder of the first forecloses and, it can be shown first at the time the first forecloses it can be shown that the property is only worth $400,000, then the foreclosing lienholder–on return to court seeking a deficiency–is limited to $50,000, regardless of what they sold the property for. So if they pay a commission of 6% ($24,000, and additional closing costs of $5,000, that $29,000 is generally barred. As for the holder of the $150,000 second? They can still come after the borrower for full payment, assuming, of course, such an action isn’t barred by one or the other of the above rules.
5. The 3 Month Rule: CCP §580a.
This rule applies only in the case of judicial foreclosures. What’s that? Literally, it is a lawsuit in which the lender obtains a “decree of foreclosure” from a court–by definition not using the trustee’s sale procedure–and is unable to be made whole from the sale of the property. Example: Loan balance of $500,000. Lender obtains a “decree of foreclosure” from a court, after which it then goes out and sells the property for $400,000. In order to get a recourse judgment against the borrower for the $100,000 shortfall, that creditor must bring an action within 3 months of the sale date or it is barred. An important carve out on this rule is that the 3-month limit does not apply to a sold out junior lienholder, the holder of the second in the above scenarios.
It is highly doubtful that you will have to deal with this rule without being fully aware of the issue steaming down the tracks towards you, simply because it can only happen in a judicial foreclosure. A lawsuit. As to whether or not you’ve been sued, well, you should know it. But check out my prior post Second Mortgages in California: Deficiencies Not Usually an Issue I referred to in my first paragraph above if you’re not sure.
As David Letterman would say, “please don’t try this at home,” by which I mean simply that if you are concerned that you may have a deficiency exposure, call a lawyer. A real estate lawyer, not a family lawyer, a personal injury lawyer or your Grandma Tilly’s trust and estates lawyer. This can be complicated stuff.
And last, of course, if the debt is discharged in bankruptcy, there is no deficiency at all. But that’s another post altogether.
Okay, so misinformation and confusion about the tax implications of foreclosure arising from the cancellation of debt seems to be piling up. In particular, folks seem most confused by the receipt of Form 1099-A from lenders who have taken property back in foreclosure.
First, remember the basic principle: Cancellation of debt MAY result in taxable ordinary income. [Note added 3/31/11: The link is to IRS Publication 4681. This is a 2008 version of this publication, and that as I write this addendum note in March 2011, the IRS has not updated the publication.]
There are three exceptions:
1. First, if the property lost in foreclosure is a principal residence–literally the home in which you live–then the cancellation of the debt (“COD”) generally won’t be taxable. This is a result of the Mortgage Forgiveness Debt Relief Act of 2007.
2. Second, if your are “insolvent” at the time that the debt is cancelled (not at the time of the foreclosure, but more on this below) then you will not be taxed. Insolvency is a simple balance sheet test: If your liabilities exceed your assets, you are insolvent. Don’t over think it. You will have to submit IRS Form 982 with the tax return in the applicable year in order to demonstrate that insolvency.
3. Third, if the debt is cancelled as a result of a bankruptcy filing, then there is also no tax. (This is one of the reasons I call bankruptcy “the ultimate mortgage modification tool.”)
(Follow the “more” tag below for the rest of this article…The really good stuff.)
After letting the world flounder for a year on what the Mortgage Forgiveness Debt Relief Act actually means, and how it intends to help taxpayers wade through the issues, the IRS has finally issued some insights. I don’t believe this is the last word on this issue, and, for reasons I discuss elsewhere on this site, I suspect that this is just the start of many problems to come. My crystal ball says that we won’t really understand the depth of this problem until 2013 or 2015 when the audits of taxpers from 2007 through 2010 start being conducted and wind through the courts.
NOTICE: This isn’t my post; It is a verbatim reproduction of the IRS’s FAQ on the Mortgage Forgiveness Debt Relief Act.
If you owe a debt to someone else and they cancel or forgive that debt, the amount of the canceled debt may be taxable.
The Mortgage Debt Relief Act of 2007 generally allows taxpayers to exclude income from the discharge of debt on their principal residence. Debt reduced through mortgage restructuring, as well as mortgage debt forgiven in connection with a foreclosure, qualifies for the relief.
This provision applies to debt forgiven in calendar years 2007 through 2012. Up to $2 million of forgiven debt is eligible for this exclusion ($1 million if married filing separately). The exclusion does not apply if the discharge is due to services performed for the lender or any other reason not directly related to a decline in the home’s value or the taxpayer’s financial condition.
The following are the most commonly asked questions and answers about The Mortgage Forgiveness Debt Relief Act and debt cancellation:
What is Cancellation of Debt?
If you borrow money from a commercial lender and the lender later cancels or forgives the debt, you may have to include the cancelled amount in income for tax purposes, depending on the circumstances. When you borrowed the money you were not required to include the loan proceeds in income because you had an obligation to repay the lender. When that obligation is subsequently forgiven, the amount you received as loan proceeds is normally reportable as income because you no longer have an obligation to repay the lender. The lender is usually required to report the amount of the canceled debt to you and the IRS on a Form 1099-C, Cancellation of Debt.
Here’s a very simplified example. You borrow $10,000 and default on the loan after paying back $2,000. If the lender is unable to collect the remaining debt from you, there is a cancellation of debt of $8,000, which generally is taxable income to you.
Is Cancellation of Debt income always taxable?
Not always. There are some exceptions. The most common situations when cancellation of debt income is not taxable involve:
- Qualified principal residence indebtedness: This is the exception created by the Mortgage Debt Relief Act of 2007 and applies to most homeowners.
- Bankruptcy: Debts discharged through bankruptcy are not considered taxable income.
- Insolvency: If you are insolvent when the debt is cancelled, some or all of the cancelled debt may not be taxable to you. You are insolvent when your total debts are more than the fair market value of your total assets.
- Certain farm debts: If you incurred the debt directly in operation of a farm, more than half your income from the prior three years was from farming, and the loan was owed to a person or agency regularly engaged in lending, your cancelled debt is generally not considered taxable income.
- Non-recourse loans: A non-recourse loan is a loan for which the lender’s only remedy in case of default is to repossess the property being financed or used as collateral. That is, the lender cannot pursue you personally in case of default. Forgiveness of a non-recourse loan resulting from a foreclosure does not result in cancellation of debt income. However, it may result in other tax consequences.
These exceptions are discussed in detail in Publication 4681.
What is the Mortgage Forgiveness Debt Relief Act of 2007?
The Mortgage Forgiveness Debt Relief Act of 2007 was enacted on December 20, 2007 (see News Release IR-2008-17). Generally, the Act allows exclusion of income realized as a result of modification of the terms of the mortgage, or foreclosure on your principal residence.
What does exclusion of income mean?
Normally, debt that is forgiven or cancelled by a lender must be included as income on your tax return and is taxable. But the Mortgage Forgiveness Debt Relief Act allows you to exclude certain cancelled debt on your principal residence from income. Debt reduced through mortgage restructuring, as well as mortgage debt forgiven in connection with a foreclosure, qualifies for the relief.
Does the Mortgage Forgiveness Debt Relief Act apply to all forgiven or cancelled debts?
No. The Act applies only to forgiven or cancelled debt used to buy, build or substantially improve your principal residence, or to refinance debt incurred for those purposes. In addition, the debt must be secured by the home. This is known as qualified principal residence indebtedness. The maximum amount you can treat as qualified principal residence indebtedness is $2 million or $1 million if married filing
Does the Mortgage Forgiveness Debt Relief Act apply to debt incurred to refinance a home?
Debt used to refinance your home qualifies for this exclusion, but only to the extent that the principal balance of the old mortgage, immediately before the refinancing, would have qualified. For more information, including an example, see Publication 4681.
How long is the relief offered by the Mortgage Forgiveness Debt Relief Act in effect?
It applies to qualified principal residence indebtedness forgiven in calendar years 2007 through 2012.
Is there a limit on the amount of forgiven qualified principal residence indebtedness that can be excluded from income?
The maximum amount you can treat as qualified principal residence indebtedness is $2 million ($1 million if married filing separately for the tax year), at the time the loan was forgiven. If the balance was greater, see the instructions to Form 982 and the detailed example in Publication 4681.
If the forgiven debt is excluded from income, do I have to report it on my tax return?
Yes. The amount of debt forgiven must be reported on Form 982 and this form must be attached to your tax return.
Do I have to complete the entire Form 982?
No. Form 982, Reduction of Tax Attributes Due to Discharge of Indebtedness (and Section 1082 Adjustment), is used for other purposes in addition to reporting the exclusion of forgiveness of qualified principal residence indebtedness. If you are using the form only to report the exclusion of forgiveness of qualified principal residence indebtedness as the result of foreclosure on your principal residence, you only need to complete lines 1e and 2. If you kept ownership of your home and modification of the terms of your mortgage resulted in the forgiveness of qualified principal residence indebtedness, complete lines 1e, 2, and 10b. Attach the Form 982 to your tax return.
Where can I get IRS Form 982?
If you use a computer to fill out your return, check your tax-preparation software. You can also download the form at IRS.gov, or call 1-800-829-3676. If you call to order, please allow 7-10 days for delivery.
How do I know or find out how much debt was forgiven?
Your lender should send a Form 1099-C, Cancellation of Debt, by February 2, 2009. The amount of debt forgiven or cancelled will be shown in box 2. If this debt is all qualified principal residence indebtedness, the amount shown in box 2 will generally be the amount that you enter on lines 2 and 10b, if applicable, on Form 982.
Can I exclude debt forgiven on my second home, credit card or car loans?
Not under this provision. Only cancelled debt used to buy, build or improve your principal residence or refinance debt incurred for those purposes qualifies for this exclusion. See Publication 4681 for further details.
If part of the forgiven debt doesn’t qualify for exclusion from income under this provision, is it possible that it may qualify for exclusion under a different provision?
Yes. The forgiven debt may qualify under the insolvency exclusion. Normally, you are not required to include forgiven debts in income to the extent that you are insolvent. You are insolvent when your total liabilities exceed your total assets. The forgiven debt may also qualify for exclusion if the debt was discharged in a Title 11 bankruptcy proceeding or if the debt is qualified farm indebtedness or qualified real property business indebtedness. If you believe you qualify for any of these exceptions, see the instructions for Form 982. Publication 4681 discusses each of these exceptions and includes examples.
I lost money on the foreclosure of my home. Can I claim a loss on my tax return?
No. Losses from the sale or foreclosure of personal property are not deductible.
If I sold my home at a loss and the remaining loan is forgiven, does this constitute a cancellation of debt?
Yes. To the extent that a loan from a lender is not fully satisfied and a lender cancels the unsatisfied debt, you have cancellation of indebtedness income. If the amount forgiven or canceled is $600 or more, the lender must generally issue Form 1099-C, Cancellation of Debt, showing the amount of debt canceled. However, you may be able to exclude part or all of this income if the debt was qualified principal residence indebtedness, you were insolvent immediately before the discharge, or if the debt was canceled in a title 11 bankruptcy case. An exclusion is also available for the cancellation of certain nonbusiness debts of a qualified individual as a result of a disaster in a Midwestern disaster area. See Form 982 for details.
If the remaining balance owed on my mortgage loan that I was personally liable for was canceled after my foreclosure, may I still exclude the canceled debt from income under the qualified principal residence exclusion, even though I no longer own my residence?
Yes, as long as the canceled debt was qualified principal residence indebtedness. See Example 2 on page 13 of Publication 4681, Canceled Debts, Foreclosures, Repossessions, and Abandonments.
Will I receive notification of cancellation of debt from my lender?
Yes. Lenders are required to send Form 1099-C, Cancellation of Debt, when they cancel any debt of $600 or more. The amount cancelled will be in box 2 of the form.
What if I disagree with the amount in box 2 of IRS Form 982?
Contact your lender to work out any discrepancies and have the lender issue a corrected Form 1099-C.
How do I report the forgiveness of debt that is excluded from gross income?
(1) Check the appropriate box under line 1 on Form 982, Reduction of Tax Attributes Due to Discharge of Indebtedness (and Section 1082 Basis Adjustment) to indicate the type of discharge of indebtedness and enter the amount of the discharged debt excluded from gross income on line 2. Any remaining canceled debt must be included as income on your tax return.
(2) File Form 982 with your tax return.
My student loan was cancelled; will this result in taxable income?
In some cases, yes. Your student loan cancellation will not result in taxable income if you agreed to a loan provision requiring you to work in a certain profession for a specified period of time, and you fulfilled this obligation.
Are there other conditions I should know about to exclude the cancellation of student debt?
Yes, your student loan must have been made by:
(a) the federal government, or a state or local government or subdivision;
(b) a tax-exempt public benefit corporation which has control of a state, county or municipal hospital where the employees are considered public employees; or
(c) a school which has a program to encourage students to work in underserved occupations or areas, and has an agreement with one of the above to fund the program, under the direction of a governmental unit or a charitable or educational organization.
Can I exclude cancellation of credit card debt?
In some cases, yes. Nonbusiness credit card debt cancellation can be excluded from income if the cancellation occurred in a title 11 bankruptcy case, or to the extent you were insolvent just before the cancellation. See the examples in Publication 4681.
How do I know if I was insolvent?
You are insolvent when your total debts exceed the total fair market value of all of your assets. Assets include everything you own, e.g., your car, house, condominium, furniture, life insurance policies, stocks, other investments, or your pension and other retirement accounts.
How should I report the information and items needed to prove insolvency?
Use Form 982, Reduction of Tax Attributes Due to Discharge of Indebtedness (and Section 1082 Basis Adjustment) to exclude canceled debt from income to the extent you were insolvent immediately before the cancellation. You were insolvent to the extent that your liabilities exceeded the fair market value of your assets immediately before the cancellation.
To claim this exclusion, you must attach Form 982 to your federal income tax return. Check box 1b on Form 982, and, on line 2, include the smaller of the amount of the debt canceled or the amount by which you were insolvent immediately prior to the cancellation. You must also reduce your tax attributes in Part II of Form 982.
My car was repossessed and I received a 1099-C; can I exclude this amount on my tax return?
Only if the cancellation happened in a title 11 bankruptcy case, or to the extent you were insolvent just before the cancellation. See Publication 4681 for examples.
Are there any publications I can read for more information?
(1) Publication 4681, Canceled Debts, Foreclosures, Repossessions, and Abandonments (for Individuals) is new and addresses in a single document the tax consequences of cancellation of debt issues.
(2) See the IRS news release IR-2008-17 with additional questions and answers on IRS.gov.
I get a lot of questions about bankruptcy basics: What’s the difference between Chapters 7, 11 and 13: What is a discharge? What can I keep? What will I lose?
Here, without fanfare or embellishment, is how the federal government describes the process. All in all, I think it’s a pretty good presentation, though of course, it lacks the “inside baseball” reality from the trenches that you can get from an attorney who spends a lot of time in the Bankruptcy Court. For that, you’ll have to pick up a phone.
I do not claim authorship of the following: It is extracted verbatim from the Federal Court’s website, and the link to the original is here. I have omitted sections relating to Chapters 9 and 12 as they don’t apply to the vast majority of people. If you have been told that they might apply to you, then check the link above.
Over the coming weeks I will also reprint some of the specific information on Chapters 7 and 13.
Article I, Section 8, of the United States Constitution authorizes Congress to enact “uniform Laws on the subject of Bankruptcies.” Under this grant of authority, Congress enacted the “Bankruptcy Code” in 1978. The Bankruptcy Code, which is codified as title 11 of the United States Code, has been amended several times since its enactment. It is the uniform federal law that governs all bankruptcy cases.
The procedural aspects of the bankruptcy process are governed by the Federal Rules of Bankruptcy Procedure (often called the “Bankruptcy Rules”) and local rules of each bankruptcy court. The Bankruptcy Rules contain a set of official forms for use in bankruptcy cases. The Bankruptcy Code and Bankruptcy Rules (and local rules) set forth the formal legal procedures for dealing with the debt problems of individuals and businesses.
There is a bankruptcy court for each judicial district in the country. Each state has one or more districts. There are 90 bankruptcy districts across the country. The bankruptcy courts generally have their own clerk’s offices.
The court official with decision-making power over federal bankruptcy cases is the United States bankruptcy judge, a judicial officer of the United States district court. The bankruptcy judge may decide any matter connected with a bankruptcy case, such as eligibility to file or whether a debtor should receive a discharge of debts. Much of the bankruptcy process is administrative, however, and is conducted away from the courthouse. In cases under chapters 7, 12, or 13, and sometimes in chapter 11 cases, this administrative process is carried out by a trustee who is appointed to oversee the case.
A debtor’s involvement with the bankruptcy judge is usually very limited. A typical chapter 7 debtor will not appear in court and will not see the bankruptcy judge unless an objection is raised in the case. A chapter 13 debtor may only have to appear before the bankruptcy judge at a plan confirmation hearing. Usually, the only formal proceeding at which a debtor must appear is the meeting of creditors, which is usually held at the offices of the U.S. trustee. This meeting is informally called a “341 meeting” because section 341 of the Bankruptcy Code requires that the debtor attend this meeting so that creditors can question the debtor about debts and property.
A fundamental goal of the federal bankruptcy laws enacted by Congress is to give debtors a financial “fresh start” from burdensome debts. The Supreme Court made this point about the purpose of the bankruptcy law in a 1934 decision:
[I]t gives to the honest but unfortunate debtor…a new opportunity in life and a clear field for future effort, unhampered by the pressure and discouragement of preexisting debt.
Local Loan Co. v. Hunt, 292 U.S. 234, 244 (1934). This goal is accomplished through the bankruptcy discharge, which releases debtors from personal liability from specific debts and prohibits creditors from ever taking any action against the debtor to collect those debts. This publication describes the bankruptcy discharge in a question and answer format, discussing the timing of the discharge, the scope of the discharge (what debts are discharged and what debts are not discharged), objections to discharge, and revocation of the discharge. It also describes what a debtor can do if a creditor attempts to collect a discharged debt after the bankruptcy case is concluded.
Six basic types of bankruptcy cases are provided for under the Bankruptcy Code, each of which is discussed in this publication. The cases are traditionally given the names of the chapters that describe them.
Chapter 7, entitled Liquidation, contemplates an orderly, court-supervised procedure by which a trustee takes over the assets of the debtor’s estate, reduces them to cash, and makes distributions to creditors, subject to the debtor’s right to retain certain exempt property and the rights of secured creditors. Because there is usually little or no nonexempt property in most chapter 7 cases, there may not be an actual liquidation of the debtor’s assets. These cases are called “no-asset cases.” A creditor holding an unsecured claim will get a distribution from the bankruptcy estate only if the case is an asset case and the creditor files a proof of claim with the bankruptcy court. In most chapter 7 cases, if the debtor is an individual, he or she receives a discharge that releases him or her from personal liability for certain dischargeable debts. The debtor normally receives a discharge just a few months after the petition is filed. Amendments to the Bankruptcy Code enacted in to the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 require the application of a “means test” to determine whether individual consumer debtors qualify for relief under chapter 7. If such a debtor’s income is in excess of certain thresholds, the debtor may not be eligible for chapter 7 relief.
Chapter 13, entitled Adjustment of Debts of an Individual With Regular Income, is designed for an individual debtor who has a regular source of income. Chapter 13 is often preferable to chapter 7 because it enables the debtor to keep a valuable asset, such as a house, and because it allows the debtor to propose a “plan” to repay creditors over time – usually three to five years. Chapter 13 is also used by consumer debtors who do not qualify for chapter 7 relief under the means test. At a confirmation hearing, the court either approves or disapproves the debtor’s repayment plan, depending on whether it meets the Bankruptcy Code’s requirements for confirmation. Chapter 13 is very different from chapter 7 since the chapter 13 debtor usually remains in possession of the property of the estate and makes payments to creditors, through the trustee, based on the debtor’s anticipated income over the life of the plan. Unlike chapter 7, the debtor does not receive an immediate discharge of debts. The debtor must complete the payments required under the plan before the discharge is received. The debtor is protected from lawsuits, garnishments, and other creditor actions while the plan is in effect. The discharge is also somewhat broader (i.e., more debts are eliminated) under chapter 13 than the discharge under chapter 7.
Chapter 11, entitled Reorganization, ordinarily is used by commercial enterprises that desire to continue operating a business and repay creditors concurrently through a court-approved plan of reorganization. The chapter 11 debtor usually has the exclusive right to file a plan of reorganization for the first 120 days after it files the case and must provide creditors with a disclosure statement containing information adequate to enable creditors to evaluate the plan. The court ultimately approves (confirms) or disapproves the plan of reorganization. Under the confirmed plan, the debtor can reduce its debts by repaying a portion of its obligations and discharging others. The debtor can also terminate burdensome contracts and leases, recover assets, and rescale its operations in order to return to profitability. Under chapter 11, the debtor normally goes through a period of consolidation and emerges with a reduced debt load and a reorganized business.
The bankruptcy process is complex and relies on legal concepts like the “automatic stay,” “discharge,” “exemptions,” and “assume.” Therefore, the final chapter of this publication is a glossary of Bankruptcy Terminology which explains, in layman’s terms, most of the legal concepts that apply in cases filed under the Bankruptcy Code.
My clients get tired of hearing me say it, but if the mantra for real estate values is location, location, location, then the mantra for bankruptcy petition and schedule preparation is disclose, disclose, disclose. This isn’t Chicken Little screaming about the sky falling; it’s real and it can have real consequences.
The 8th Circuit Court of Appeals recently decided the case of In re Barrows. In that case, the debtors borrowed money from their 401(k) just before their bankruptcy petition was filed, and deposited the funds into their bank account. They didn’t tell their lawyer about it. On their bankruptcy schedules, they disclosed–under penalty of perjury–that their combined bank balance was $325 on the day of filing. The trustee requested bank statements, and those statements revealed the additional funds. When their lawyer sought to amend the exemption schedules to include the additional funds apparently mistakenly omitted, the Court denied the amendment and the debtor’s appealed. They lost the case and, therefore, their $13,000.
The Court of Appeal reasoned that, because the debtors signed their schedule under penalty of perjury, such omissions can’t be cured by simple amendments. The Court upheld the lower court decision, and the debtor’s lost the $13,000.
The most painful–and truly absurd–irony of this tale, however, is that, because the money was borrowed from the debtor’s 401(k) retirement account, and would have been exempt if either a) They had waited until after filing to borrow the money, or b) Correctly disclosed the bank balance and source of the funds. The important issue for the Court of Appeal wasn’t whether the funds would have been reachable by the creditors or the trustee, but the debtor’s “bad faith” in failing to be truthful in the schedules. In other words, the doctrine of “no harm, no foul” doesn’t apply. This kind of stuff drives me nuts because it is so easily avoidable.
I take three lessons from this:
1. Don’t expect post petition amendments to cure material omissions without the threat of some possible consequence.
2. Truth matters. A lot. Innocence alone doesn’t vitiate inaccuracy.
3. If you are untruthful in your schedules, you should expect to be caught.
Here in the Northern District of California, Judge Alan Jaroslovsky of the Santa Rosa Division wrote an Open Letter to Debtors and their Counsel in 1997 with regard to the casual assumption that inaccuracies can be easily cured with later amendments. You can read the original order here.
But to quote the most important message from the 1997 Open Letter, Judge Jaroslovsky says:
Whatever your attitude is toward the schedules, you should know that as far as I am concerned they are the sacred text of any bankruptcy filing. There is no excuse for them not being 100% accurate and complete. Disclosure must be made to a fault. The filing of false schedules is a federal felony, and I do not hesitate to recommend prosecution of anyone who knowingly files a false schedule.
That’s worse than losing $13k.
One of the best options for people facing foreclosure is the “deed in lieu of foreclosure,” or as it’s more frequently referred to, “deed in lieu.”
Essentially, this is the fancy legal term for what most folks would describe as “mailing the keys to the lender,” or as it’s being called lately, “jingle mail.” Giving the the house back to the bank instead of waiting for it to foreclose. There are some good reasons for doing this if you have the option.
The best reason for doing it is that you avoid any risk of the lender seeking a deficiency judgment for the amount by which the loan balance exceeds the property value. (That’s assuming the lender has that right, which, in most cases in California at least, they probably don’t. But that’s a whole different issue and beyond the scope of this post.) The reason is that the deed in lieu documentation will include a release…That’s the quid pro quo that you get from the lender in exchange for saving themthe cost, legal expenses, time and procedural brain damage of having to go through the foreclosure process. This is critical: Do NOT do a deed in lieu if you don’t get the release!!!
The other good reason is that it expedites what is a painful and stressful process that most people would rather avoid. You can be in and out fairly quick.
However, generally, it won’t work if you have more than one loan. The reason is that, by taking the property by deed, rather than by foreclosure, the lender accepting the deed takes subject to the continuing obligation to pay any other existing encumbrances. This is true whether the lender is in first, second or third position; if you get deeded a property, you take subject to the continuing obligation to pay other existing loans which are still of record. In this current environment, most people have two or more loans, making the deed in lieu an impossibility. The foreclosure process actually wipes out junior deeds of trusts, or loans.
So if you’re considering a deed in lieu, or if some cocktail party lawyer has suggested it, before getting too excited about it, the two big questions to answer are whether you need it, or whether it is even possible.
Now, first off, I know that the title I’ve chosen for this post is about as unsexy and non-juicy as it can be. That’s okay. I can take it. It’s boring. I can hear marketing consultants hollering about how I need to make my title more grabby, sticky, etc. Yawn. What can I say? Trying to make this stuff fun and exciting is like trying to turn a root canal into a spectator sport. And besides, if you’re reading this, you didn’t come here to be entertained. Maybe someday I’ll change the title but for the moment it stays.
So, anyhow, on the subject of deficiencies…
Far and away the most common question I get asked by clients and potential clients is whether they will be liable for what’s called a “deficiency” after they let a property go in foreclosure. Please note that the discussion below is limited to California law. If your property is not in California–it doesn’t matter where you are; what matters is where the property is–then the discussion below will not apply to your situation because the laws in each state about foreclosures and deficiencies is unique to each state’s laws.
First, what is a deficiency anyhow?
A deficiency is, simply defined, the difference between what you owe on your loan(s) minus the value of the property at the time of the foreclosure. Here’s an absurdly over-simplified example: You owe $250,000 on the loan. At the time of the foreclosure, the property value is $200,000. If the lender is entitled to a deficiency (and that’s a HUGE “if” in California) then it would be calculated at $50,000 ($250,000 – $200,000 = $50,000)
Lots of people right now are trying to weigh their options about whether they want to let a property go in foreclosure, file bankruptcy, do a “short sale,” try for one of those “deeds in lieu” or even try to work something out with the lender. (Right!) What I am seeing quite frequently is that decisions are being made based on completely wrong information about the extent to which they are at risk for
Next, how do you evaluate the risk of being chased for a deficiency by a lender after foreclosure?
Here are the rules in as simple a way as I can articulate them. Remember: THESE APPLY ONLY TO LOANS SECURED BY PROPERTY IN CALIFORNIA. If you don’t live in California, then these rules DO NOT apply to you.
1. There can be no deficiency on a purchase money loan. Ever. This means that if the loan was used to purchase the property, then no deficiency is possible. It doesn’t matter if the holder of the first, second or third forecloses. If the loan on which a lender is trying to get a deficiency is a purchase money loan, then no deficiency is possible. There are wrinkles in this: A HELOC can be purchase money. A loan taken out to refi a purchase money loan cannot. If you have multiple loans, then you have to think about the purpose of the loan. Let’s say you have a purchase money first, and then you later took out a second. The second, because the loan proceeds weren’t used as “purchase money,” that lender is not barred from pursuing a deficiency in a lawsuit.
2. There can be no deficiency if the lender exercises its power of sale and conducts a non-judicial foreclosure by the mechanism of a trustee’s sale. In order to get a deficiency, the lender MUST file a judicial foreclosure action. That means that they have to sue you in Superior Court. Some people seem confused about whether that piece of paper then got in the mail was a lawsuit or something else. It’s hard to miss: It’s a big 8.5? x 11? document called a “Summons,” and it says in unambiguous writing: “Notice to Defendant….You Are Being Sued By Plaintiff.” See a copy of one on my post “Second Mortgages in California: Deficiencies Not Usually an Issue.”